Summary
The derivative market has grown to such a massive proportion due to the speculative activities and the intention of the players to make quick profit. The market operation in derivatives requires only the margin money which is about one tenth of the value of underlying security, the expansion of credit in the derivative market depends on the liquidity flow and each operator's ability for risk taking. However, simultanous credit expansion in the economy, flow of funds from productive investment to speculative operations, and the reckless operations of several big players had fuelled the expansion of derivative market out of proportion, and its ultimate collapse. The operators inject more and more funds into the derivative trading, which reduces the availability of funds/credits in other economic areas, and the failure of some of the operators triggers the fire, and the collapse of the market, effecting normal economic activities badly.
Analysis
How will the extended leverage used by the speculators in the derivative market affect the real economy is the question under the present situation of market collapse. Before arriving at a conclusion as to the remedies to be adopted to prevent the repetition of such a situation, a thorough analysis of the underlying transactions is to be carried out.
Today’s market is flooded with different kinds of derivatives, such as derivatives of securities, derivatives of commodities, derivatives of book debts etc. etc. The intention of the parties entering into the contract of purchase/sale of derivatives is to make profit out of the fluctuating price variance in the underlying securities. Since the margin needed for derivative trading is only a fraction of the price of underlying security, contracts are entered for several times the original value. It may also be seen that in such transaction, the valuation of underlying security is also not done on the basis of “cost plus”, or “book value”, but on the basis of the fundamental economic principles of demand and supply. The availability of credit in the market decides the prices of the instrument, and simultaneously the price of derivatives, and the underlying security moves in the same direction. When the market reverses, there is no stoppage, and the losses to the players are ultimate, and depend upon the quantum of holding of every player.
The failure of Barings Bank in 1995 due to the reckless operations of Nick Leeson in securities derivative in Singapore market, and the heavy losses suffered by Sumitomo Corporation of Japan in 1996 in commodity derivatives are the glaring examples of risk attached with derivatives. Though above examples are isolated cases of failures, in the recent turmoil, there are several such players involved, and the losses suffered by them are heavy and very extensive. The proposal of US government to bail out the suffering operators, and infusing funds by the European governments may not be sufficient to make up the losses suffered by the operators, as the losses is several times the global GDP. The global GDP as per the latest IMF survey is $45 Trillion, and a conservative estimation of the derivative market is about $1300 Trillion. A reasonable estimation of the net economic loss is very difficult, as the same involves investigation to each case and ascertaining the losses. About six months ago, when the IMF estimated more than $ 1 trillion in financial sector losses, and at that time, not many cases of failures were reported. With much of the losses yet to be realized, and with the financial crisis now acute, it has become clear that the stop-gap solutions will not work, and taking comprehensive steps in tackling the immediate fallout and addressing the root causes will give the much awaited respite to the economy. The immediate step to be taken is to permit the derivative market to unwind, and come to a level of real economic risk protection –and not for speculative losses. Further steps to be taken are (1) To make Liquidity Provisions (2) Purchase of distressed assets (3) Capital injection into financial institutions. The recent IMF proposal for a solution based on longer-term swaps of mortgage securities for government bonds – which cleans up bank balance sheets in the near term but leaves the long-term risks with banks, not the state – shall be just and acceptable for a long term solution.
Further, strict regulations must be at place for the derivatives market, and the transaction should not be permitted to reach the level of extreme speculation. The world has already seen the prices of commodities including oil, and even the food items shooting up which was the result of speculative derivatives transactions. The recent developments and the failure of the financial system show that the money is moving from productive activities to the speculative spectrum where quick profit is expected without much value addition. Therefore steps are needed to be taken to restrict the credit flow from the economic activities to the speculative activities.
